The NEW Normal Environment


A’s for Everyone!

The trend towards coddling American children has been broadly documented in recent years by social commentators, comedians, and talk show hosts (and occasionally in my own household!). Every child gets a trophy at the end of each season, every child is a standout student, and all children get their turn playing the lead in the play. In short, everybody is a winner!

It seems like the same can be said of active bond managers over the past five years. A look at the Morningstar Intermediate Term Bond Universe for the five years (ending 9/30/13) shows that an amazing 77% beat the benchmark for the Universe, Barclays Aggregate Bond Index (Figure 1).

Figure 1. Morningstar Intermediate-Term Bond Universe – 5-Year Returns Ending 9/30/13

It is reassuring to know that most of the players on this team are way above average. Yet the efficient market theory (EMT), innovated by 2013 Nobel laureate Dr. Eugene Fama, would suggest that this burst of alpha in the Intermediate-Term Bond Universe runs counter to modern financial theory. Indeed, a look at the historical fraction of funds that have outperformed the benchmark over rolling five-year periods going back to 1992 (21.5 years) reveals that, on average, less than one third of the funds in the universe have been able to beat the benchmark over the last 21.5 years, versus 77% over the last five years (Figure 2). Not only is the long-term average fairly low at 29% (expected due to expenses), but there are also many periods when less than 10% of managers outperformed. Moreover, prior to 2012, this long-term history contained only one period in which more than 50% of the managers had outperformed the benchmark.

For your information, a Glossary of Terms is provided at the end of this white paper. If you have any questions concerning the content of this white paper, please feel free to contact TCW Corporate Communications at 213-244-0000.

Figure 2. A’s for Everyone!
% of Intermediate-Term Funds Outperforming Barclays Aggregate Bond Index on a Trailing 5-Year Basis1

Given that the long-term record of active bond managers seems rather average (again, as expected due to fees and expenses), what has caused this recent cornucopia of alpha? We would posit that it has to do with rewards to systemic risk taking. The chart below (Figure 3) shows yield premiums (spreads) on investment grade corporate bonds (lagged five years) versus the percentage of managers outperforming the benchmark index on a trailing 5-year basis. The chart demonstrates that when yield premiums are historically high at the beginning of the five-year period more managers outperformed. In fact, the correlation between the two series is as high as 61%, and this is just one systemic risk factor. The relationship with other systemic risk variables, such as mortgage spreads and the slope of the yield curve, is also positively correlated with manager outperformance.

Figure 3. A’s for Everyone???
% of Intermediate-Term Managers Outperforming vs. Corporate Bond Yield Spreads (lagged 5 years)

1 Based on rolling 5-year returns of funds in Morningstar Intermediate-Term Bond Universe. Funds that have multiple share classes are represented by the oldest share class.

2 Source: Citi BIG Index, Yieldbook.

The most recent observations of manager outperformance are of great interest as they represent extreme outliers in the data history. Given that this period begins with the financial crisis of late 2008, systemic risk at the start of the period was priced at the most attractive level in modern history. Hence, managers with even modest overweights to systemic risk variables would have been likely to achieve alpha over the most recent five-year period. We would argue that the Federal Reserve’s large scale asset purchase program (QE) is one of the main drivers of the increased systemic risk taking by managers. We believe that by adding significant liquidity to the markets, the Fed has essentially signaled to market participants that it is backstopping the taking of risk. Moreover, while not stated explicitly by policymakers, we believe that one of the aims of Quantitative Easing (QE) was to produce liquidity in risk markets (corporate bonds, high yield, non-agency MBS, equities, etc.) by crowding investors out of low risk markets (U.S. Treasuries, Agency MBS) and encouraging risk taking. In doing so during a period when risk and liquidity premiums were very high, we believe that Fed effectively created a unique period during which the generation of alpha in U.S. fixed income was remarkably fruitful. The fact that four out of five periods when more than 50% of managers outperformed the index in the last 21.5 years coincide with the Fed’s historic QE program points strongly to the notion that the Fed has had a meaningful influence on risk taking and returns in the active management of bonds. So, we feel the Fed has been handing out A’s to active bond managers, but with yield premiums back near long-term averages and the Fed discussing withdrawal from QE, we would conclude that:

Ease May Be Over (the Fed)...But
Easy is Definitely Over!

For further confirmation that the recent results in active fixed income were extraordinary we examined risk-adjusted returns of funds in Intermediate-Term Bond universe over significantly longer period and analyzed the current and historical yield premiums on risky asset classes. The complete analysis, which can be accessed on the financial advisor/investment professional section of our website, concludes that as the Fed continues to look for an exit strategy from large scale asset purchases (QE) and with spreads back at long-term average levels (and below), the environment for risk taking in active fixed income management is becoming normal again. In short, with the great ease slowing or perhaps even ending, we think that easy is over for active managers. We believe that good managers with disciplined risk allocation processes and the ability to add value from true market inefficiencies can still add significant alpha, but gone will be the days when almost everyone added alpha.

Please see the glossary of terms below.

Glossary of Terms

Active management – a combination of investment strategies employed by a portfolio manager with the goal of exploiting market inefficiencies and outperforming the benchmark index.

Alpha – a measure of active return on investment in excess of benchmark index.

Correlation – a statistical measure of how the prices or returns of two or more securities (or portfolios) move in relation to each other. A negative correlation between returns of two securities implies that if the first security is generating positive returns then the second security would be expected to generate negative returns.

Capital Asset Pricing Model (CAPM) – a financial model that estimates the expected return of a risky asset based on risk-free rate, expected market premium, and a measure of sensitivity to systematic risk (beta coefficient) of the risky asset.

Efficient Market Theory (EMT) – also known as Efficient Market Hypothesis, is a financial theory (developed by Nobel laureate Eugene Fama) which states that financial markets are informationally efficient and hence, it is impossible to consistently outperform the market on a risk adjusted basis.

Liquidity Premium – the yield premium (additional return) demanded by investors for holding a security which cannot be easily converted into cash at fair market value.

Market inefficiencies – distortions on financial markets that cause securities to trade above or below their fair market value due to behavioral biases or structural/regulatory factors.

Modern financial theory – here, the reference is made to the Efficient Market Theory (EMT).

Mortgage spread – risk premium that investors require for holding a mortgage-backed security.

Overweight – a condition where the portfolio exposure to a given asset class (or risk measure) exceeds that of the
benchmark index.

Quantitative Easing (QE) – also known as Large-Scale Asset Purchase Program (LSAP), is an unconventional monetary policy initiated by the U.S. Federal Reserve Bank (the Fed) in 2008 to stimulate the U.S. economy in the aftermath of the 2007 2009 financial crisis. The Fed implemented QE by buying U.S. Treasury and U.S. Agency Mortgage-Backed securities thus increasing the prices of these securities and lowering the yields on them in order to entice investors into other areas that might be more beneficial for an economic rebound.

Risk allocation – the process of allocating capital across risky asset classes, credit quality spectrum, duration/maturity bands, and points on the interest rate curve.

Risk Markets – here, risky asset classes, including IG bonds, HY bonds, Non-Agency Mortgages, equities, Emerging Market bonds/equities, etc.

Risk Premium – also known as “yield premium,” is the minimum rate of return demanded by holders of a risky asset in excess of the return on a risk-free asset with similar maturity and duration profile.

Systematic risk – risk affecting the entire financial market (as opposed to the risk affecting a single security or a small group of securities) which cannot be diversified away.

Volatility – a measure of the risk of price moves for a security calculated from the standard deviation of day-to-day logarithmic historical price changes.

Yield Curve – a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.

Any issuers or securities noted in this document are provided as illustrations or examples only, for the limited purpose of analyzing general market or economic conditions, and may not form the basis for an investment decision. TCW makes no representation as to whether any security (or the security of any issuer) mentioned in this document is now or ever was held in any TCW portfolio. TCW is not recommending the purchase, sale or holding of any security and is making no representation or indication of its own holdings of any securities. TCW may in fact be currently recommending the purchase of a security or the sale of a security regardless of any statement made in this document about that security or whether TCW owns it or not. Discussion of securities in this document are strictly for educational use only and are not intended to serve as investment advice. Any statement made in this document, including any statement or implication drawn from any discussion of individual securities, is subject to change at any time, without notice.

For Information Only

This publication is for general information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision.

Subject to Change

Any opinions expressed are current only as of the time made and are subject to change without notice. TCW assumes no duty to update any such statements. The views expressed herein are solely those of the author and do not represent the views of TCW as a firm or of any other portfolio manager or employee of TCW. Any holdings of a particular company or security discussed herein are under periodic review by the author and are subject to change at any time, without notice. In addition, TCW manages a number of separate strategies and portfolio managers in those strategies may have differing views or analysis with respect to a particular company, security or the economy than the views expressed herein.

MetWest is a wholly-owned subsidiary of The TCW Group, Inc.